[Economic Report of the President (2005)]
[Administration of George W. Bush]
[Online through the Government Printing Office, www.gpo.gov]


 
CHAPTER 1

The Year in Review and the Years Ahead



The recovery of the U.S. economy blossomed into a full-fledged
expansion in 2004, with solid output growth and steady improvement
in the labor market. Payroll employment increased by about 2.2 million
jobs, the largest annual gain since 1999, and the economy expanded
3.7 percent during the four quarters of the year. The economy made
these advances even as energy prices soared, the Federal Reserve raised
interest rates, and the demand-side effects of fiscal policy stimulus
began to recede in the second half. Such continued growth indicates
that the economy has shifted from a policy-supported recovery to a
self-sustaining, healthy expansion.
This chapter reviews the economic developments of 2004 and discusses
the Administration's forecast for the years ahead. The key points in
this chapter are:

 Real gross domestic product (GDP) grew solidly during 2004.
Business investment in equipment and software accelerated, and
consumer spending growth remained strong.
 Labor markets strengthened during the year. The
unemployment rate continued to decline, and employers created more
than 2 million new jobs.
 Inflation rose from the extremely low levels of 2003,
partly because of rapid increases in energy prices. Nevertheless,
core consumer price index (CPI) inflation has remained in the moderate
2 percent range, and inflation expectations remain low.
 The Administration's forecast calls for the economic
expansion to continue this year, with real GDP growing faster than
its historical average and the unemployment rate continuing to
decline. The economy is expected to continue on a path of strong,
sustainable growth.


Developments in 2004 and the Near-Term Outlook

Real GDP grew a robust 3.7 percent during the four quarters of 2004,
above the average historical pace. (Real GDP growth was 4.4 percent
on a year-over-year basis comparing GDP for 2004 as a whole with GDP
for 2003 as a whole.) Growth was supported by gains in consumer
spending, business fixed investment, and, to a lesser extent,
housing investment, inventory accumulation, and government
spending. Net exports (exports less imports) held down growth in
all four quarters as the trade deficit rose in the third quarter
to a record high as a percentage of GDP. Strengthening economic
growth among our trading partners led to an increase in exports,
but imports continued to outpace exports as U.S. domestic demand
and demand for imported oil remained strong. The rise in crude oil
prices reduced growth somewhat during the year (Box 1-1).
The Administration expects real GDP to grow 3.5 percent during
the four quarters of 2005, in line with the consensus of
professional forecasters. This growth is forecast to be driven by
continued gains in consumer spending, investment growth (although
slower than in 2004), and stronger net exports. The unemployment
rate, which declined 0.5 percentage point to 5.4 percent during the
four quarters of 2004, is projected to edge down further to
5.3 percent by the fourth quarter of 2005. Nonfarm payroll
employment, which grew about 180,000 per month during 2004, is
projected to grow about 175,000 per month in 2005, in line with
other professional forecasts.
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Box 1-1: Oil Prices and the Economy

Rising oil prices hindered growth in 2004. Boosted by strong world
demand and both domestic and foreign supply disruptions, the price of
crude oil purchased by refiners increased almost continuously from $29
per barrel in December 2003 through October 2004 when it peaked at $46
per barrel. A more-widely followed (but less comprehensive) measure,
the spot price of West Texas Intermediate crude oil, peaked even
higher, at $53 per barrel for the month of October. These prices were historical highs in nominal terms, and were about 60 percent of the
all-time high in real terms (Chart 1-1). Crude oil prices then dropped
off in November and December. For 2004 as a whole, refiners'
acquisition cost was almost $9 per barrel above its year-earlier level.
High oil prices are a headwind for the economy because they raise the
cost of production, thus weakening the supply side of the economy, and
absorb income that could have been used for other purchases, thus
weakening the demand side of the economy. The United States imports
about two-thirds of its crude oil (about 10 million barrels per day),
and so the higher oil prices caused the bill for imported oil to
increase by about $32 billion (or 0.3 percent of GDP) in 2004.  This
increase acted like a tax holding back aggregate demand.
One rule of thumb is that a $10 per barrel increase in the price of
oil reduces the level of real GDP by roughly 0.4 percent after four
quarters. Thus the roughly $9 per barrel increase in average oil
prices for 2004 may have held back real GDP growth by 0.3 or 0.4
percentage point. If oil prices move as expected by the futures market, average oil prices in 2005 will only slightly exceed the 2004
average--so oil prices are expected to be only a minor impediment to
2005 growth.
----------------------------------------------------------------------





Consumer Spending
Consumer spending continued its solid growth in 2004. Real personal
consumption expenditures, which account for 70 percent of GDP, rose
3.9 percent during the four quarters of 2004. Consumer spending has
been boosted by continued gains in disposable personal income and a
rebound in household wealth. Real disposable personal income--after-tax
income adjusted for inflation--rose by 2.3 percent at an annual rate
during the first 11 months of 2004. Household net worth, meanwhile,
grew at a 6 percent annual rate in the first three quarters of 2004
(on top of a 13-percent gain during 2003), as equity prices moved up
and housing prices continued to increase.
Personal saving fell to 0.8 percent of disposable personal income in
the first 11 months of the year, down from an average of 1.4 percent
in 2003. The Administration forecast assumes that the saving rate
will be roughly flat in the coming years. Consumer spending is
projected to continue its solid growth in 2005, supported by solid
consumer sentiment (which was above average historical levels in
December), projected real compensation gains, and the recent rebound
in household wealth. Real consumer spending is projected to grow
somewhat more slowly than overall real GDP during the projection
period to 2010.

Residential Investment
The housing sector remained strong through year-end 2004. Residential
investment increased 6 percent during the four quarters of 2004,
following a 12 percent gain during 2003. Demand for new housing has
been stimulated by low mortgage rates. Rates on 30-year fixed-rate
mortgages averaged 5.8 percent in 2004--about the same as a year
earlier, but lower than at any other time in the past 30 years.
Sales of new single-family homes during 2004 were the highest since
at least 1963, when the government began tracking this information,
and the homeownership rate was a record 69 percent.
The strength in housing demand has been reflected in home prices.
An index of prices for houses involved in repeat transactions (that
is, sales prices of the same house over time) increased by 13 percent
during the four quarters ended in the third quarter of 2004--the
biggest four-quarter increase since the late 1970s. The rapid
increase in demand and prices has further helped support gains in
home construction. Housing starts totaled 1.95 million units during
2004, making it the strongest year for housing starts since 1978.
The growth of new housing starts will likely slow in 2005. Long-term
Treasury rates are projected to increase, leading mortgage rates to
edge up as well. In addition, demographics suggest that the
formation of new households is unlikely to support additional
increases in housing activity. Taken together, these factors suggest
that residential construction is likely to edge lower in the next
couple of years and to remain roughly flat during the years through
2010.

Business Fixed Investment
Real business fixed investment (firms' outlays on equipment,
software, and structures) grew 9.9 percent during 2004, following
a 9.4 percent gain during 2003. Growth was concentrated in equipment
and software (up 13.6 percent), while nonresidential construction
edged lower. Within the equipment and software category, growth
during the four quarters of 2004 was particularly strong in computer
equipment and software. Investment in transportation equipment also
grew rapidly in 2004, overtaking its pre-9/11 level in the fourth
quarter.
Nonresidential structures investment edged down during the four
quarters of 2004, with a notable decline in investment in power
and communications facilities. Real nonresidential construction
has been stagnant since 2002, as vacancy rates in both office and
industrial buildings have remained high. Construction of shopping
centers and other multi-merchant structures has been robust,
however.
Projections of future investment growth are based, in part, on the
observation that growth in investment spending correlates well with
the acceleration (that is, the change in the growth rate) of business
output (Chart 1-2); the





reasons for this correlation are discussed
more fully in Chapter 2, Expansions Past and Present. Equipment
investment spending grew quite fast during 2003 and 2004, consistent
with the rapid acceleration of nonfarm output growth from 2001 to
2003. The 3.5 percent growth projected for real GDP during the four
quarters of 2005 is solid but below the growth rates of 2003 and
2004. It follows, therefore, that the growth of investment is
likely to be slower in 2005 than in 2004. In addition, the
termination of the special investment expensing provisions allowed
under the Jobs and Growth Tax Relief Reconciliation Act of 2003
(JGTRRA) is likely to have advanced into 2004 some investment
spending that might have been planned for early 2005. The end of
this policy could limit investment growth in the first quarter of
2005.

Business Inventories
Businesses rebuilt inventories in 2004; inventory investment was
solidly positive during the year, after being slightly negative in
2003. Inventory investment contributed an average of 0.35 percentage
point to real GDP growth during the four quarters of 2004.
Inventories appear to be lean relative to economy-wide sales and
shipments, with the inventory-to-sales ratio for manufacturing
and trade close to its historic low. Assessing just how lean these
inventories are is difficult, however, as ongoing improvements in
supply-chain management (such as just-in-time practices, discussed
in Chapter 2) have reduced the need for inventory stocks.
Inventories grew almost as fast as sales in 2004, and the
inventory-to-sales ratio for manufacturing and trade edged down
only slightly last year. Inventory investment in 2005 is projected
to be sufficient to hold the inventory-to-sales ratio approximately
constant, and the pace of inventory investment is projected to
contribute little to GDP growth in 2005.

Government Purchases
Real Federal purchases (consumption expenditures and gross investment)
grew at a 4 percent rate during the four quarters of 2004, with most
of that growth accounted for by defense spending. Total nominal
Federal expenditures (including transfer and interest payments)
slowed to a 5 percent rate of growth during 2004 from a 6 percent
rate in 2003.
After several difficult years, the budget position of states and
localities improved recently due to a combination of spending
restraint and renewed growth of revenues. The level of real state
and local consumption and gross investment was little changed during
2004, the lowest growth in real spending since the early 1980s.
State and local revenues have been boosted by increased household
income and consumer spending, as well as by additional federal
grants authorized under JGTRRA. Spending restraint, together with
a pickup in revenues, boosted the net saving of state and local
governments to roughly $11 billion during the first three quarters
of 2004, roughly reversing the dissaving during the year-earlier
period. Real state and local spending is projected to pick up from
last year's slow growth, to about 2 percent per year during the
projection period.

Exports and Imports
The trade deficit expanded substantially during 2004. Real exports
increased 4 percent, as economic growth strengthened among our major
trading partners, but real imports increased even faster (at a
9.2 percent rate), partly due to the more robust recovery in the
United States than abroad. The trade deficit on goods and services
reached about 5 1/4 percent of GDP in the third quarter of 2004.
The rapid increases in real imports were widespread and included
capital goods and industrial supplies, petroleum, and consumer goods.
All the major categories of real nonagricultural exports (capital
goods, industrial supplies, motor vehicles, consumer goods, and
services) contributed to the growth of overall exports. Agricultural
exports declined, however, as exports of beef fell on concerns about
``mad cow'' disease. Due to the detection of the first known case of
``mad cow'' disease in the United States in late 2003, a number of
countries that together account for most U.S. beef exports have
completely or partially halted purchases of American beef. As a
result, beef exports--which were $3.1 billion in 2003--have now fallen
to about $0.5 billion at an annual rate.
The rapid growth of imports relative to exports largely reflects
faster growth in the United States than among our trading partners,
as U.S. demand for imports increases faster than foreigners' demand
for our exports. For example, the U.S. economy grew faster than its
trading partners in the Organization for Economic Cooperation and
Development (OECD) during the four quarters of 2003 (4.4 percent
versus 2.2 percent), and the OECD growth estimate for the four
quarters of 2004 also shows slower growth elsewhere in the
OECD (2.7 percent) than the 3.7 percent official estimate of growth
for the United States.
The current account deficit, which primarily reflects the trade
deficit but also includes net international flows of investment
income and transfers, widened to about 5.6 percent of GDP in the
second and third quarters. The current account deficit represents
the inflow of capital that is needed to finance domestic U.S.
investment in excess of domestic saving. Over the latter half of
the 1990s and the early 2000s, the U.S. current account deficit
expanded as domestic investment grew faster than saving (Chart 1-3).
More recently, the current account deficit has expanded as the
national saving rate has fallen.



Looking ahead, stronger growth in U.S. trading partners appears
to favor continued gains in export growth. Growth among the non-U.S.
members of the OECD is projected to increase from 2.7 percent during
the four quarters of 2004 to 3.0 percent during the four quarters of
2005. This growth should support growth in U.S. exports. This effect
will likely be augmented by an expected rise in the U.S. share of
world exports, owing in part to recent declines in the value of the
dollar against other major currencies. Overall, the Administration
projects real exports to grow noticeably faster than GDP in 2005.
The projected moderation of U.S. GDP growth in 2005 and 2006 together
with the recent change in the exchange value of the dollar suggest
that growth in real imports will slow in the future.

Employment
Nonfarm payroll employment increased about 2.2 million during 2004,
the largest annual gain since 1999. The unemployment rate declined
to 5.4 percent in December 2004, well below the 6.3 percent peak of
June 2003. The unemployment rate in 2004 was below the averages of
the 1970s, the 1980s, and the 1990s.
Job gains were spread broadly across major industry sectors in 2004.
The service-providing sector accounted for 85 percent of job growth
during the year, in line with its 83 percent share of overall
employment. The goods-producing sector accounted for the remaining
15 percent of the gains, in line with its 17 percent share of
overall employment. Within the goods-producing sector, employment
growth was concentrated in construction; manufacturing employment
also increased, the first such gain since 1997.
These employment figures reflect the benchmark adjustment of the
employment data in early February 2005. The employment data for 2004
will also be affected by next year's benchmarking process, which will
cover the period from March 2004 to March 2005.
The Administration projects that employment will increase at a pace
of about 175,000 jobs per month on average during the 12 months of
2005--a projection that is in line with the consensus of private
forecasters. The unemployment rate is projected to edge down to
5.3 percent by the fourth quarter of 2005. Employment growth is not
expected to slow by as much as output growth because productivity
(output per hour) is projected to increase at a slower pace than in
2004, and more of the projected output growth may be translated into
labor demand and employment in 2005 than in 2004.

Productivity
Recent productivity growth has been extraordinary. Nonfarm
productivity has grown at a 4.2 percent annual rate since the
business-cycle peak in the first quarter of 2001, a period that
includes both recession and recovery. This is a 1.8 percentage
point acceleration from the already rapid 2.4 percent annual growth
rate recorded from 1995 to 2001 (Chart 1-4).
Although the cause of the 1995 acceleration is not well understood,
plausible explanations have been offered relating to capital
deepening, especially of informational and organizational capital.
But none of these explanations helps to explain the post-2000
productivity acceleration, which occurred despite a slowing of
investment in both conventional capital goods and information
technology (IT).

Wages and Prices
Following very low inflation during 2003, most measures of inflation
increased during 2004, with the largest increases in those price
indexes that include energy. For example, the consumer price index
(CPI) increased 3.3 percent over the 12 months of 2004, well above
the 1.9 percent rise





during the previous year. Excluding the volatile
food and energy components, core consumer prices increased 2.2 percent
during 2004, up from 1.1 percent during 2003. About 0.4 percentage
point of the year-to-year acceleration in the core CPI is accounted
for by used car prices, which dropped sharply in 2003 before
rebounding in 2004. Consumer energy prices increased 17 percent in
2004--with particularly large (27 percent) increases in petroleum-
based energy prices. Food prices increased 2.7 percent during 2004,
down slightly from their 3.6 percent rise in 2003.
Hourly compensation of workers grew solidly during the year, mostly
because of rising benefits. Private-sector hourly compensation, as
measured by the employment cost index (ECI), increased 3.8 percent
during the 12 months of 2004--down slightly from its 4.0 percent
year-earlier pace. The wages and salaries component of this measure
rose 2.4 percent during the year, while benefits increased by
6.9 percent. The increase in hourly benefits was led by an increase
in employer contributions to defined benefit programs--which increased
at a 66 percent annual rate during the first three quarters of 2004,
according to the employer costs for employee compensation index
(derived from the same survey as the ECI, but with different
weights). This rapid increase occurred as employers made ``catch-up''
contributions to their pension plans to offset some of the
underfunding that developed in recent years. Employer-paid health
premiums rose 7.3 percent during 2004 according to the ECI, a smaller
increase than the 10.5 percent during 2003.
The effects of these gains in hourly compensation on unit labor costs
were mostly offset by the rapid growth rate of productivity during
the first three quarters of 2004. Unit labor costs rose at only a
0.7 percent annual rate during the first three quarters of 2004,
after falling from 2001 through 2003. Most of the increase in prices
during 2004 was attributable to widening gross profit margins rather
than to increasing costs, suggesting some tightness in product
markets. Consistent with this product-market tightness, delivery
lags lengthened during the first half of 2004, as reported by
manufacturing supply managers. These supply delivery lags increased
much more slowly toward year-end, however, and the experience of the
last two expansions suggests that these lags are likely to recede as
the economy reconfigures itself for sustained growth.
Last year's increase in inflation appears likely to have been a
temporary phenomenon rather than the beginning of a sustained
increase. Inflation, as measured by the CPI, is expected to stabilize
at a 2.4 percent annual rate in future years, up only slightly from
the 2.2 percent increase in the core CPI during 2004. In 2005 and
2006, the overall consumer price index is projected to be held down
by anticipated declines in energy prices consistent with the declines
implicit in the futures market for crude oil. The inflation
fluctuations during the past year have not affected long-term
inflation expectations, which remain stable (Chart 1-5).




The projected path of inflation as measured by the GDP price index is
similar, but a bit lower. It is projected to fall to 1.9 percent
during the four quarters of 2005, down slightly from the 2.2 percent
annual rate of increase in the GDP price index excluding food and
energy during 2004. During the next several years, the GDP price
index is projected to increase at a 2.0 or 2.1 percent annual
rate--a stable pace of inflation consistent with the projected
unemployment rate of 5.1 percent.
These inflation projections--although revised up from a year ago--are
close to those of the consensus of professional economic forecasters.
The wedge between the CPI and the GDP measures of inflation has
implications for Federal budget projections. A larger wedge would
reduce the Federal budget surplus because cost-of-living adjustments
for Social Security and other indexed programs rise with the CPI,
whereas Federal revenue tends to increase with the GDP price index.
For a given level of nominal income, increases in the CPI also cut
Federal revenue because they raise income tax brackets and affect
other inflation-indexed features of the tax code. Of the two
indexes, the CPI tends to increase faster in part because it measures
the price of a fixed basket of goods and services. In contrast, the
GDP price index increases less rapidly because it reflects the choice
of households and businesses to shift their purchases away from items
with increasing relative prices and toward items with decreasing
relative prices. In addition, the GDP price index includes investment
goods, such as computers, whose relative prices have been falling
rapidly. Computers, in particular, receive a much larger weight in
the GDP price index (1 percent) than in the CPI (0.2 percent).
During the 10 years ended in 2003, the wedge between inflation in
the CPI-U-RS (a historical CPI series designed to be consistent with
current CPI methods) and the rate of change in the GDP price index
averaged 0.4 percentage point per year. The wedge was particularly
high during 2004 when the CPI increased 1.0 percentage point faster
than the GDP price index, reflecting the roughly 50 percent increase
in oil prices, which have a much larger weight in consumption prices
than in GDP as a whole. Since domestic production accounts for only
about a third of U.S. oil consumption, the weight of oil prices in
GDP is roughly one-third of its weight in the consumption basket.
As this boost from higher oil prices unwinds over the next couple
of years, the wedge between CPI and GDP inflation is likely to be
lower than its recent average. During the entire 2004 to 2010
period, the wedge is projected to average 0.4 percentage point,
equal to the Administration estimate of the wedge in the long term.


Financial Markets
Stock prices fluctuated within a relatively narrow range for the
first eight months of the year, and then increased during the last
four months. Over the 12 months of 2004, the Wilshire 5000, a broad
index of stock prices, rose 11 percent. These gains built on the
29 percent gains that were recorded during 2003.
Long-term interest rates fluctuated substantially during 2004, but
finished the year essentially unchanged. The yield on 10-year
Treasury notes fell by 0.3 percentage point from January through
March, to about 3.8 percent. The yield then increased sharply in the
next two months, rising 0.9 percentage point, coinciding with a
pickup in the core CPI and several months of strong job growth.
Rates began to fall again in early June, as monthly increases in
the core CPI and job growth moderated. The 10-year rate declined
during the second half of the year, even as the Federal Reserve's
Open Market Committee raised the (overnight) Federal funds rate at
every meeting from June through December. The 10-year rate ended
the year at about the same level as it had begun.

The Long-Term Outlook Through 2010

The U.S. economy continues to be well-positioned for long-term growth.
The Administration projects that GDP will expand strongly through
2010, inflation will remain contained, and labor markets will
continue to strengthen. The forecast is based on conservative
economic assumptions that are close to the consensus of professional
forecasters. These assumptions provide a prudent and cautious basis
for the budget projections.


Growth in GDP over the Long Term
The Administration projects that real GDP will grow at an average
annual rate of 3.3 percent during the four years of 2005 to 2008
(Table 1-1), roughly in line with the consensus forecast for those
years. This pace is slightly above the expected 3.2 percent annual
growth in potential GDP (a measure of productive capacity), so
the unemployment rate is projected to edge lower from 5.4 percent
at the end of 2004 to 5.1 percent by the end of 2006. The
unemployment rate is expected to remain flat thereafter as the
economy grows at its potential rate of 3.2 percent in 2007 and
2008 and 3.1 percent in 2009 and 2010. As discussed below,
potential GDP growth is expected to slow somewhat after 2008, as
labor force growth declines.
The projected growth of GDP is conservative relative to recent
experience. The economy grew more than 4 percent during 2003 and is
estimated to have grown 3.7 percent during the four quarters of
2004. Moreover, Okun's Law, a well-known economic rule of thumb,
suggests that potential GDP growth has been about 3.5 percent in
recent years (Box 1-2).



------------------------------------------------------------------------
Box 1-2: Okun's Law

One way of estimating the economy's potential growth rate is through
the empirical regularity known as Okun's Law, which relates changes in
the unemployment rate to GDP growth (Chart 1-6). The chart plots the
four-quarter change in the unemployment rate (which has been adjusted
to account for demographic changes) against the four-quarter growth
rate of real output. According to Okun's Law, the unemployment rate
falls when output grows faster than its potential rate and rises when
output growth falls short of that potential. The rate of real GDP
growth consistent with a stable unemployment rate is then interpreted
as the rate of potential growth; this potential can be estimated as the
rate at which the fitted line in Chart 1-6 crosses the horizontal axis.
As can be seen by the position of the two parallel lines, the pace of potential real GDP growth appears to have picked up after 1995. The
lower line, which is drawn through data for 1980-1995, suggests that
potential real GDP grew at a 2.8 percent annual rate during those years.
The upper line--which is drawn through data for 1996-2004 and is
estimated so as to be parallel to the lower line--suggests that real
potential GDP growth accelerated to a 3.5 percent annual rate during
the past nine years.
-----------------------------------------------------------------------





The growth rate of the economy over the long run is determined by
its supply-side components, which include population, labor force
participation, productivity, and the workweek. The Administration's
forecast for the contribution of different supply-side factors to
real GDP growth is shown in Table 1-2.
As seen in the fourth column of the table, the supply-side composition
of real GDP growth has been unusual since the beginning of 2001,
with exceptionally high productivity growth (4.2 percent at an annual
rate) being partially offset by a large decline in the ratio of
nonfarm business employment to household employment. This unusual
pattern reflects the discrepancy between the slow growth of
employment as measured by the employer survey and the more rapid
growth of employment as measured by the household survey--a disparity
that has not been adequately explained.  Declines in the labor force
participation rate have also held down real GDP growth during the
past four years, although the reasons for these declines may be
partly cyclical.






The 4.2 percent rate of productivity growth during the past three
and a half years is remarkable, particularly because this period
included a recession, and is well above the already strong
2.4 percent productivity growth experienced from 1995 to 2001. The
causes of the post-2001 productivity acceleration remain a mystery
at this time, and so it seems unwise to presume that the rapid
growth of the last few years will be sustained indefinitely.
The Administration expects nonfarm labor productivity to grow at a
2.5 percent annual pace over the next six and a quarter years. This
is a bit below the assumed 2.6 percent trend rate of growth, similar
to the 2.4 percent pace during the 1995-2001 period, and only
modestly above the 2.3 percent average pace since the data series
began in 1947.
Growth of the labor force (also shown in Table 1-2) is projected to
contribute 1.0 percentage point per year, on average, to growth of
potential output through 2010. Labor force growth results from
changes in the working-age population and the participation rate.
The Bureau of the Census projects that the working-age population
will grow at an average annual rate of 1.1 percent through 2010.
This pace is more rapid in the near future and then trails off
after 2008. The last year in which the labor force participation
rate increased was 1997, suggesting that the long-term trend of
rising participation has ended. Since then, the participation rate
has fallen at an average 0.2 percent annual pace.
Demographic factors will likely lead to yet lower participation in
future years. Baby boomers are currently in their forties and
fifties. Over the next several years they will move into older age
brackets with lower participation rates. As a result, the labor
force participation rate is projected to edge down an average of
0.1 percent per year through 2010. The decline may be greater,
however, after 2008, which is the year that the first baby boomers
reach the early-retirement age of 62. Together with the expected
deceleration of the growth of the working-age population, the
falling participation rate works to slow the growth rate of
potential output to 3.1 percent in 2009--2010.
An expanding workweek is projected to add 0.1 percentage point to
potential GDP growth during the projection period. Most of this
increase occurs in the next couple of years during the period of
strong cyclical labor demand, rather than as a permanent feature of
long-term growth. The ratio of nonfarm employment to household
employment (which, as noted above, subtracted a puzzling 0.9
percentage point from real GDP growth during 2001-2004) is projected
to contribute nothing toward real GDP growth during the projection
period. It is possible, however, that it might reverse course
during the next few years, offsetting its recent weakness. Such a
development would add to real GDP growth.
In sum, potential real GDP is projected to grow at a 3.2 percent
annual pace through 2008, and then to slow to 3.1 percent in 2009
and 2010. Actual real GDP growth during the six-year forecast period
is projected to be slightly higher, at 3.3 percent, as the
unemployment rate declines and the workweek expands. The economy is
forecast to grow at potential beginning in 2007, and the
unemployment rate is projected to stabilize at 5.1 percent.

Interest Rates over the Long Term
The Administration forecast of interest rates is based on financial
market data as well as a survey of economic forecasters. The yield
curve, which shows how the yield on Treasury securities rises with
the maturity of those securities, is currently steeper than usual.
This steepness suggests that financial market participants expect
short-term interest rates to rise. The Administration forecast
thus projects gradual increases in the interest rate on 91-day
Treasury bills to continue through 2010--with most of the increase
expected during the next two years. This rate is expected to reach
4.2 percent in 2010, at which point the real interest rate on 91-day
Treasury bills will be close to its historical average. The projected
path of the interest rate on 10-year Treasury notes is consistent
with the path of short-term Treasury rates. By 2010, the 10-year rate
is projected to be 5.7 percent, 3.3 percentage points above expected
CPI inflation--a typical real rate by historical standards. By 2010,
the projected term premium (the difference between the 10-year
interest rate and the 91-day rate) of 1.5 percentage points is in
line with its historical average.


The Composition of Income over the Long Term
A primary purpose of the Administration's economic forecast is to
estimate future government revenues, which requires a projection
of the components of taxable income. The Administration's
income-side projection is based on the historical stability of the
long-run labor compensation and capital shares of gross domestic
income (GDI). During the first three quarters of 2004, the labor
compensation share of GDI was only 56.8 percent--well below its
1959-2003 average of 57.9 percent. From this jumping-off point,
the labor share is projected to slowly rise to 57.8 percent by
2010.
The labor compensation share consists of wages and salaries, which
are taxable, employer contributions to employee pension and insurance
funds (that is, fringe benefits), which are not taxable, and
employer contributions for government social insurance. The
Administration forecasts that the wage and salary share of
compensation will be roughly stable during the projection period.
One of the main factors boosting non-wage compensation during the
past two years has been employer contributions to defined-benefit
pension plans, and although these contributions are likely to
remain high in the next few years, they are not projected to rise
as a share of compensation after 2004.
The capital share of GDI is expected to fall from its currently
high level before plateauing near its historical average. Within the
capital share, a near-term decline in depreciation (an echo of the
decline in short-lived investment during 2001 and 2002) is expected
to boost corporate profits, which in the third quarter of 2004 were
about 10.2 percent of GDI (excluding the temporary negative effects
of hurricanes)--a figure well above its post-1959 average of
8.5 percent. From 2005 forward, the profit share is expected to
slowly edge down toward its long-term average.
The projected pattern of book profits (known in the national income
accounts as ``profits before tax'') reflects the termination of the
window for expensing of equipment investment allowed under the Job
Creation and Worker Assistance Act of 2002 and the Jobs and Growth
Tax Relief Reconciliation Act of 2003. These expensing provisions
reduced taxable profits from the third quarter of 2001 through the
fourth quarter of 2004. The expiration of the expensing provisions
increases book profits from 2005 forward, however, because investment
goods expensed during the three-year expensing window will have less
remaining value to depreciate. The share of other taxable income
(the sum of rent, dividends, proprietors' income, and personal
interest income) is projected to fall in coming years, mainly
because of the delayed effects of past declines in long-term interest
rates, which reduce personal interest income during the projection
period.

Conclusion

Supported by expansionary fiscal and monetary policy, the economy now
appears to have shifted from a tentative recovery to a sustained
expansion. Consumer spending remains strong, businesses are continuing
to invest, and employment growth has rebounded. Prospects remain bright
for continued growth in the years ahead. And yet much work remains in
making our economy as productive as possible. Later chapters of this
Report explore how pro-growth policies, such as reforming our tax
system, expanding the reach of property rights, and encouraging
innovation, can enhance our economic performance.